My usual advice is that individual stock selection is best left to the experts, and even they have a high percentage chance of messing it up. If that’s the warning for ordinary share selection; then my advice for derivatives trading is that even investment professionals should avoid it; unless they have years of experience in derivatives trading and know exactly they’re doing. Trading derivatives is even more like going to a casino than trading shares. So, this article is just for interest & information.

This isn’t an article about derivatives in general, so I’m not going to define it or provide an idea of the universe of derivatives, all I’m going to do is zone in on one particular type of derivative – a “call option“. I’m defining a call option as a financial instrument which gives the holder the right but not the obligation to purchase a specified share at a specified price on a specified date in the future. Those familiar with options will recognise this to be a European-style call option, but I’m not going into the variations in this article, and just accept for the rest of this article that when I write about a “call option” I mean the above.

So, an example of a call option is one which provides the buyer the right but not the obligation to purchase 100 IBM shares for $150 each on the 19th of January 2018. If, on the 19th of January 2018 IBM’s share price is $160, then you’ll exercise your right to buy 100 IBM shares at $150. If on the 19th January 2017 IBM’s share price is only $140, then you wont exercise your option to buy at $150, as you can buy in the open market for $140. And that’s the great thing about buying options – it is one of the safer derivative strategies, as your worst case scenario is you walk away from the deal, and it costs you your option premium. Yes, there’s an option premium – don’t think you were going to buy such an advantageous contract from somebody without having to pay for it! So, let’s say the cost of that call option is $3, then your worst case scenario is losing $3 times 100 (remember you were buying call options for 100 IBM shares). And the reason why I’m so focused on 100 shares is because that is the unit of trade with options – you trade in lots of 100 shares.

However, whilst the level of risk for the party who bought the option is low, the level of risk for the party who sold the option (the “writer”)is correspondingly high. If IBM’s share price closes at $200, then the writer will make a loss of $47 per share ($200 – $150 + $3). Theoretically, losses are unlimited as there’s no upper limit for a share price.

So, if it’s so risky, then why am I toying with the idea of writing call options? Well, there are only specific circumstances where it may make sense.

Let’s say I own 100 IBM shares and I’m wanting to sell them for $150. I have therefore placed a limit order in to sell them at $150, and instead of having to redo the order each day it doesn’t trade, I instead have submitted the order as “GTC”, “Good till Cancelled”. This means the sell order will remain in force unless I specifically cancel it. Another way of setting the Time-in-force would be “Day”, which means that at the end of the day, if the order hasn’t traded, the order will be cancelled. Using GTC saves me the hassle of having to reenter the order each day – it will sell IBM when it reaches my target price of $150.

However, since I want to sell at $150 anyway, why not write a call option which gives the buyer the write to sell to me at $150? Then if the share price rises to above $150 then the buyer will exercise his write to buy, I’ll achieve my aim of selling for $150, and have earned an additional $3 in the process.

A crucial difference though is that the call option was attached to a specific date – 19 January 2018; and whereas previously I was trying to sell at $150 no matter the date, now I’m tying it to the specific date. If IBM rises to $160 in December 2017, and falls back to below $150 by the 19th January 2018, I’ll have lost my opportunity. So, writing the call option carries this additional cost, compared to an outright GTC trade. There is no free lunch.

When selling call options on a share which you hold, this is called writing a “covered call option”.

It’s possible to implement a similar strategy, writing put options, when you want to buy a share. But, similarly, it’s unfortunately not a free lunch.

Commission

Keep a close eye on the commission you’ll pay when trading options. As option premiums earned are a small percentage of the cost of a share, the commission will typically form a much larger percentage of any option premiums you earn.

Taxation

Be aware of what tax you’ll be paying on option premium income versus capital gains you would make on holding onto a stock, and tax paid on dividends.